Collins Foods (ASX:CKF) Has A Pretty Healthy Balance Sheet

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Collins Foods Limited (ASX:CKF) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Collins Foods

What Is Collins Foods's Net Debt?

The image below, which you can click on for greater detail, shows that at October 2020 Collins Foods had debt of AU$317.8m, up from AU$297.3m in one year. On the flip side, it has AU$145.8m in cash leading to net debt of about AU$172.0m.

How Healthy Is Collins Foods's Balance Sheet?

The latest balance sheet data shows that Collins Foods had liabilities of AU$152.5m due within a year, and liabilities of AU$683.1m falling due after that. Offsetting these obligations, it had cash of AU$145.8m as well as receivables valued at AU$2.39m due within 12 months. So it has liabilities totalling AU$687.3m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Collins Foods is worth AU$1.15b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

While Collins Foods's low debt to EBITDA ratio of 1.4 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 2.7 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. If Collins Foods can keep growing EBIT at last year's rate of 11% over the last year, then it will find its debt load easier to manage. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Collins Foods can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Collins Foods generated free cash flow amounting to a very robust 92% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

On our analysis Collins Foods's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. To be specific, it seems about as good at covering its interest expense with its EBIT as wet socks are at keeping your feet warm. Considering this range of data points, we think Collins Foods is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 4 warning signs for Collins Foods (1 is significant) you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

If you’re looking to trade Collins Foods, open an account with the lowest-cost* platform trusted by professionals, Interactive Brokers. Their clients from over 200 countries and territories trade stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.